2023-03-27 06:35:19 ET
Summary
- SOXL is a 3x leveraged ETF that gives investors exposure to the ICE semiconductor index.
- The Semiconductor Index is composed of high revenue growth and high-profit margin stocks.
- Despite these strong companies, investing in SOXL comes with high risks, but potentially high rewards.
Investment Overview
The Direxion Daily Semiconductor 3x Bull Shares ETF (SOXL) is an exchange-traded fund that aims to provide three times the daily performance of the Technology Select Sector Index (IXTTR) as opposed to its 1x leveraged companion: iShares Semiconductor ETF (SOXX).
According to Direxion's fact sheet :
The Direxion Daily Semiconductor Bull 3X Shares seek daily investment results, before fees and expenses, of 300%, or 300% of the inverse (or opposite), of the performance of the ICE Semiconductor Sector Index. There is no guarantee the funds will meet their stated investment objectives.
ICE Semiconductor Index (ICESEMI) is a rules-based, modified float-adjusted market capitalization-weighted index that tracks the performance of the thirty largest U.S. listed semiconductor companies. One cannot directly invest in an index.
When analyzing the holdings of SOXL, we notice that many of these companies have high valuations despite declining revenues and profitability. For this reason, we rate SOXL a Sell.
Examining the Holdings:
Looking at SOXL's top holdings, it is, of course, no surprise that the top holdings are large-cap semiconductor companies with strong revenue growth and profit margins. To understand whether SOXL is a holding, we must first understand the semiconductor industry.
Boom and perhaps bust?
The semiconductor industry experienced significant growth following the 2020 pandemic, which resulted in global lockdowns and supply chain disruptions that halted the production of chips and chip making equipment worldwide. In 2021, there was a boom in semiconductor revenue due to a significant increase in demand and a limited supply. As a result, semiconductor stocks experienced significant gains, with SOXL climbing 70% in 2020 and 118% in 2021. However, in 2022, many semiconductor stocks suffered losses, as demand weakened and revenue growth was revised downwards, leading to shrinking profit margins.
While many semiconductor companies are still experiencing robust revenue growth due to increasing demand, it's important to recognize that the health of semiconductors is closely tied to the health of the economy. Chips are used in almost every modern product, ranging from smartphones, laptops, and automobiles, and any decline in consumer spending or business confidence could lead to a drop in semiconductor revenue and profit. In addition, the semiconductor industry is highly globalized, and disruptions in international trade or supply chains can also affect the industry's performance. Geopolitical risks, such as trade disputes, sanctions, and political instability in key regions, can also impact the industry's ability to operate effectively.
Given the looming recession and the downward revisions in guidance, investing in the semiconductor industry may be risky, especially given the high valuations of many companies. This risk is compounded when considering adding leverage to the investment equation. As such, it's essential to carefully evaluate the risks and benefits before investing in the semiconductor industry, taking into account the potential impact of economic volatility and global geopolitical risks.
Quantitative Analysis
Looking at SOXL's top 10 holdings, which make up a whopping 57% of the fund, we see that there leaves much to be desired. Seeking Alpha's Proprietary Quant score, save for Analog Devices (ADI), rates these stocks around the score of 3. Looking at our valuation and growth grade, we see that many of these companies are disappointing - indicating that these companies are trading at a premium and are failing to show the revenue and profit growth to prove they deserve that premium. Let's take a deeper dive into these companies.
Analyzing the top three holdings in the semiconductor industry, Broadcom (AVGO), Texas Instruments (TXN), and Nvidia (NVDA), it's evident that the industry experienced a boom and bust cycle from 2020 to 2022. In 2020, these companies saw significant expansion in EBITDA margins and revenues, but in 2022, both metrics drastically declined. The rapid shift in growth and profitability also resulted in a corresponding shift in semiconductor valuations. While the SOXL and SOXX ETFs increased by an impressive 118% and 44%, respectively, in 2021, the scenario was much different in 2022. In that year, SOXX saw a sharp 35% decline in value and SOXL saw a devastating 85% decline in value.
Understanding Tracking Errors
Before investors consider investing in SOXL, it is important to understand how leveraged ETFs work. SOXL is a leveraged ETF that aims to provide three times the daily returns of its underlying index, ICESEMI, through the use of financial instruments and derivatives. However, it is crucial to note that the fund explicitly states in the fact sheet that there is no guarantee that it will meet its stated investment objectives.
These leveraged ETFs seek a return that is 300% or -300% of the return of their benchmark index for a single day. The funds should not be expected to provide three times or negative three times the return of the benchmark's cumulative return for periods greater than a day.
While SOXL strives to achieve three times the performance of ICESEMI, it may fail to do so. Any tracking errors will be compounded by the 3x leverage, which could lead to significant deviations from the stated investment objective over time. Even a small tracking error of just one basis point, after continuous daily resetting of its leverage, can result in substantial tracking errors. Therefore, SOXL is more suitable as a daily trading tool than a long-term hold in your investment portfolio.
Understanding Volatility Decay
Volatility decay, also known as decay of leveraged ETFs, refers to the loss in value of a leveraged exchange-traded fund (ETF) due to the compounding effects of daily rebalancing. These ETFs use leverage to amplify returns based on the underlying index or asset, in this case by a factor of three. However, because the leverage is reset on a daily basis, the returns of the ETF can diverge significantly from the index over time. If the index experiences volatility, the ETF's returns can be significantly impacted due to the compounding effect of daily rebalancing, resulting in a decay in value over time. Volatility decay can be a significant risk for investors who hold leveraged ETFs for an extended period, as the value of the ETF may deviate significantly from the expected returns based on the underlying index or asset.
To better illustrate the concept of volatility decay, I created a hypothetical scenario where the SOXX index moves up and down for six days. Assuming no tracking errors, the SOXL ETF, which mirrors the index by a factor of three, also moves up and down accordingly. At the end of the six-day period, the SOXX index only drops by 20 basis points, whereas the SOXL ETF drops by a shocking 181 basis points. This illustrates how the daily leverage can amplify losses due to the effect of compounding. Volatility decay can significantly impact returns over time and it is imperative for investors to understand this concept and the potential risks associated with investing in leveraged ETFs before making any investment decisions.
Beta
Finally, we will discuss Beta. In essence, Beta is a measure of a stock's volatility in relation to the overall market, generally the S&P 500. Beta is calculated by comparing the returns of the stock to the returns of the market index (such as the S&P 500) over a period of time. A beta of 1 indicates that the stock has the same level of volatility as the overall market. A beta greater than 1 indicates that the stock is more volatile than the market, while a beta less than 1 indicates that the stock is less volatile than the market. Beta is used as a risk measurement tool by investors and portfolio managers to assess the risk and return potential of a particular stock or portfolio.
When we look at the top 10 holdings of SOXX, we see that save for three tickers, most companies holding high betas with NVDA having a shocking beta of 1.76. When we also consider tracking errors and volatility decay, we understand just how risky holding SOXL can be. Volatile swings in either direction can make or break our portfolio, should we consider SOXL as a long-term hold. Even as a trading device, the swings are still enormous.
Putting it all together
SOXL is a powerful investment tool that allows us to benefit from the strong growth potential of the semiconductor industry. The companies that compose the ICE semiconductor index have impressive margins and robust revenue growth, meeting the never-ending demand for their products. This growth is likely to continue for the long term, but it's important to note that their lofty valuation can fluctuate based on investor sentiment and macroeconomic changes. Leveraging these high-beta names can lead to significant returns but also significant losses. It's crucial to consider potential tracking errors and volatility decay prior to investing in SOXL as they can be the source for significant upside/downside. Before adding SOXL to our portfolio, we must exercise caution and carefully weigh the risks and benefits for both short-term and long-term investment goals. As a result, I rate the stock a Sell.
What are your thoughts on SOXL and the semiconductor industry?
To end this article, I will remind investors of a famous quote from Warren Buffet regarding leverage.
Warren Buffet:
I've seen more people fail because of liquor and leverage - leverage being borrowed money. You really don't need leverage in this world much. If you're smart, you're going to make a lot of money without borrowing."
For further details see:
SOXL: 3 Important Factors To Understand Before Buying